Lower U.S. interest rates help emerging markets regain allure

When it comes to the emerging markets, investors have tended to focus on the "BRICS" countries—Brazil, Russia, India, China and South Africa—which have large populations and significant natural resource deposits. There is, however, a lot more to emerging market investing than these five, and investors should be aware of other options as they hunt for returns in the far corners of the globe.

Emerging markets performed poorly in 2013, falling 2.6% amid concern that the withdrawal of stimulus measures by the Federal Reserve would lead to higher interest rates. That could curb foreign investment and undercut prices of basic commodities, which many emerging market countries rely on for export income. Higher domestic interest rates also make assets denominated in foreign currencies less attractive. Despite the Fed's move to "taper" its stimulus spending, U.S. interest rates have actually fallen in 2014, helping to revive demand for emerging market stocks. Collectively, emerging market stock markets have risen 4% this year (see exhibit 1).

Article Highlights

Emerging market stocks have rebounded in 2014 after slumping in 2013, reviving interest in the group from investors.

A decline in U.S. interest rates is helping to boost emerging markets stock prices.

Mexico, The Philippines and South Africa are currently the most attractive among emerging markets, we believe.

India and Indonesia are now looking expensive after strong gains earlier this year.

Stocks in Brazil and Russia are cheap, but we see significant challenges to achieving stronger growth.

Exhibit 1: Emerging market equity rally

Taken individually, however, the performance of emerging market stock markets has varied significantly, as shown below in Figure 2, reflecting their divergent growth rates, valuations, and economic challenges.

While we still see current opportunities in some emerging markets, others offer more value over the long term. Also, there are a few we are steering clear of for now. The following is a wrap up of our current views on a number of markets.

Mexico

Among individual emerging markets, we see Mexico and the Philippines as particularly promising right now. Mexico is benefitting from political reforms such as the constitutional change opening its oil and gas industry to foreign investment. Also, its economy is heavily geared toward the U.S., where growth is accelerating.

The Philippines

In the Philippines, the economy grew by 7.2% in 2013, faster than all the BRICS except China. A well educated workforce has helped the country trump India as the leading destination for investments in outsourced business processes such as call centers. Also, the Philippines' banking sector is experiencing strong growth amid rising demand for loans, improving asset quality and widening access to credit. Overall, we believe the Philippines is moving from one of Asia's worst performing economies to one of its best. While local stocks are not cheap, the country still boasts robust corporate profit growth.

South Africa

Another emerging market of interest is South Africa. The South African Rand has declined significantly against the U.S. dollar due to falling commodity prices, strikes by powerful mining unions, and a widening trade deficit. The drop in the rand, however, may be reaching the point where it will improve South Africa's international competitiveness and help to revive its currently tepid economic growth. Also, the majority of union labor contracts have been re-negotiated over the past 18 months, and a successful presidential election was held in May.

India

With India's stock market rising more than 30% so far this year, we are cautious about the potential for near-term gains, however we are still optimistic about its long-term prospects. Six months ago, domestic and foreign investors were worried about India's fiscal and current account deficits, which led to a depreciating currency. Now, the market is full of optimism for newly elected Prime Minister Modi’s aggressive reform agenda. Modi won a landslide victory in May after promising to revive India’s underperforming economy, curb inflation, simplify the national sales tax and restore investor confidence.

Brazil

Although Brazil's economy has more than quadrupled in size over the last decade, we are underweighting the country for now. Growth has decelerated recently, the middle class has become disenchanted with President Dilma Rousseff's government and investors have begun to worry about the country's budget deficit and persistent inflation. It is now common to hear frustration from both investors and middle-class Brazilians over the country's low productivity, poor infrastructure, bloated public sector, and entrenched bureaucracy. The market is cheap – shares in the national oil company Petrobras are trading near a nine-year low – but we expect heightened volatility there until the October presidential election.

South Korea and China

Elsewhere, South Korea should benefit in the long-term from its exposure to China, even though China’s economic growth has slowed from its blistering pace in recent years. Overall, Chinese stocks seem inexpensive, trading at price-to-earnings ratios far below their 2007 peak. While Chinese economic growth may slow, it should still be able to maintain a fairly robust 7% pace. Even so, investors are concerned that property values appear to be weakening, which could put pressure on local banks. Also, investors want to see structural reforms that reduce China’s dependence on massive public infrastructure spending and exports, particularly as sales to the U.S. and Europe have been mostly stagnant this year.

Indonesia

Indonesia is another market that we believe merits caution. Stocks there have risen by about 15% in the first five months of the year, buoyed by anticipation that populist Jakarta Governor Joko Widodo, known as "Jokowi," will win the presidential election set for July and deliver much needed reforms such as reducing government fuel subsidies. While Jokowi is leading current polls, most voters are still undecided, and his ability to pass politically unpopular subsidy cuts is unclear. Also, the country's lack of investment in infrastructure is hindering foreign investment.

Russia

While some investors may find Russia attractive due to its valuation discount, we note that it has historically been one of the cheapest emerging markets. Also, the economy is slowing and may enter recession later this year, adding to the already considerable geo-political risks investors in the country face. On the bright side, growth and tax revenue are heavily weighted to oil prices, which have risen recently.

Long-Term Growth Prospects

Overall, we believe emerging markets are generally attractive for long-term investors. Despite their shortcomings, these countries have young, working-age populations and a growing middle class, both of which bode well for future economic growth and corporate profits. That said, not every emerging market country represents an attractive investment opportunity currently. We think investors should choose an actively managed emerging market investment strategy, one that differentiates between emerging market locales, sectors and individual securities since returns and volatility may vary greatly.

Please note investments in foreign securities are subject to special risks, including currency fluctuation and political and economic instability.

Please note investments in foreign securities are subject to special risks, including currency fluctuation and political and economic instability.